In the event of a crash, how to take the opportunity to trigger big capital losses and restructure your portfolio at the same time

JewishWorldReview.com |
Tax season reminds me just how much I love a good stock market crash. When my accountant recently informed me that I wouldn't have to pay taxes on nearly $50,000 in profits I netted last year from the sale of stocks (including three in the Practical Investing portfolio), it occurred to me that I should share my crash-oriented portfolio-restructuring and -rebalancing strategy.

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In a nutshell: I save big moves for times of crisis. That allows me to rejigger the mix of stocks, bonds and cash in my portfolio and to trigger losses at the same time. My method is not as meticulous as the regular rebalancing that most advisers encourage. But for those of us with taxable accounts who are willing to accept a little financial messiness, my strategy can work nicely.

You see, the greatest thing about capital losses is that they never expire. Tax rules allow you to use losses to offset gains, plus up to $3,000 in ordinary income, every year. When you have excess losses, you get to roll them forward to be used in future years. So when you have an opportunity to trigger big losses--far more than you'd be able to use in a year--and to rebalance or restructure your portfolio at the same time, you should jump at the chance. After all, that sort of opportunity doesn't come along every day. You really need a market crash like those that occurred in 2002 and 2008. Eventually, we'll have another bear market--and perhaps another crash--so it pays to be prepared.

The best way to explain it is with an example. Back in 2008, when the market was falling through the floor, I sold my main mutual fund holding, Vanguard Total Stock Market Index (symbol VTSAX). I had built up the holding over the previous ten years by making regular monthly contributions into a taxable account.

Why a taxable account? Mainly because of its flexibility. I have assets in tax-deferred retirement accounts, too. But because you have to pay income taxes on withdrawals from IRAs, 401(k) plans and the like (and generally penalties on withdrawals made before age 59 1/2 ), you shouldn't use the money in those kinds of accounts for emergencies or, say, to buy a car. I think everyone should have money in a taxable account for such needs.

My taxable account was worth more than $300,000 at one point, well over my cost of roughly $257,000. When the market dropped in late 2008, the account's value fell to $177,000. Selling triggered an $80,000 loss.

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MY STOCK-MARKET SWEEP
The moment the sale cleared, I started buying. I didn't want to repurchase shares in the same fund, and I couldn't if I wanted to preserve the tax losses. (Tax rules bar claiming a tax loss when you repurchase the same or "substantially identical" shares within a month of a sale.) My portfolio was loaded with big-company stocks, and I had wanted to shift money into smaller companies and real estate stocks for some time, but didn't want to trigger taxable gains. The market upheaval gave me the chance to make the move with positive tax consequences.

I like what this restructuring did for my portfolio, too. I put the proceeds into three exchange-traded stock index funds: Half went to Vanguard Mid-Cap ETF (VO), 25% to Vanguard Real Estate InvestmentTrust ETF (VNQ) and the rest to Vanguard Large Cap ETF (VV). While all stock indexes have been soaring since the bull market began in 2009, the mid-cap and REIT ETFs have performed extraordinarily well. Over the past five years through March 7, both funds have more than tripled in value (including reinvested dividends). I'll have to pay taxes on those gains eventually, of course, but not anytime soon.